Overvalued ‘unicorn’ startups stumble as they get reality check

Square, the 6-year-old company known for its white, card readers that plug into smartphones, has been growing rapidly, but it is also burning through a lot of
cash despite raising hundred of millions of dollars from investors.

Square, the 6-year-old company known for its white, card readers...

The soaring unicorns are falling back to Earth.

In the past two years, investors have valued dozens of startups — companies like Uber, Airbnb, Dropbox and Snapchat — at $1 billion or more, fantastical numbers that earned the companies the nickname of the mythical one-horned horse. But as Square prepares to go public Thursday, all signs point to a major reality check.

More Mind Your Business

Earlier this month, Square, the San Francisco payments processor, said it expects Wall Street to value the company at up to $4.2 billion, considerably less than its original estimate of $6 billion. And late Wednesday, Reuters reported that Square could set its initial public offering price at $9, well below its earlier forecasted range, pushing the company’s valuation still lower. Last month, Pure Storage in Mountain View had its stock finish almost 6 percent lower than its original price of $17 per share during its first day of trading.

For investors to make money, a startup either goes public or gets bought, actions known as exits. But so far this year, five out of seven exits for tech unicorns earned a lower valuation than previous estimates, according to a report by Upfront Ventures in Los Angeles. By contrast, the same was only true for three out 12 exits in 2014.

‘A bubble’

“The market is rapidly correcting,” Mark Suster, the managing partner of Upfront Ventures who authored the report, said in an interview. “Valuations have gotten out of control. By any definition, I don’t think you can say what’s happening is anything other than a bubble.”

That’s not to say none of the unicorns are worth their private valuations. But in the rush to find the next Uber or Airbnb, investors ranging from traditional venture capitalists and mutual funds to investment banks and corporations have been throwing gobs of money at startups that probably don’t deserve it.

Over the past 18 months alone, the number of technology unicorns has nearly tripled to more than 80 companies.

The mega-values assigned to unicorns have even led to talk that companies don’t even need to go public — that they can somehow stay private indefinitely, continually raising venture capital to fund their activities and allowing investors in only through the burgeoning private stock markets.

But Square’s situation clearly refutes that theory. The 6-year-old company has been growing rapidly, but Square is also burning through a lot of cash despite raising hundreds of millions of dollars from investors.

In 2014, Square generated $850.2 million, compared with $203 million two years prior, according to documents filed with the Securities and Exchange Commission. But the company’s operating losses jumped to $150.5 million from $85.4 million in the same period.

Starbucks partnership

Square’s decision to go public also coincides with a disastrous partnership with Starbucks that the two companies recently ended. Last year, the Starbucks program, which allowed people to pay for coffees using Square’s tablet-based mobile payments system rather than traditional cash registers, cost Square $151 million to run. The partnership generated only $123 million in revenue, so Square essentially lost $28 million on the deal.

Now, Square needs cash, which is why the company is going public Thursday. But unlike private investors, Wall Street investors are not as impressed with these unicorns.

“Public investors have not lost their heads over the rapid growth of these companies,” said Matthew Kennedy, an analyst with Renaissance Capital in Greenwich, Conn., a research firm that focuses on IPOs.

For one thing, the public markets represent the collective wisdom of many more investors than a few select venture capitalists. And public-market investors are also much more aware of global uncertainty, meaning that recent turmoil in the Chinese and European stock markets sends more than a ripple of anxiety through U.S. investors.

Careful venture firms

Nevertheless, “I don’t think venture firms want to be holding onto these unicorns longer than they have to,” Kennedy said.

With the Federal Reserve poised to raise interest rates in December, expect more unicorns to fall short of their private valuations, said Kevin Kinsella, founder of Avalon Partners, a San Diego venture capital firm. Rising interest rates normally push investors toward more cautious assets like bonds instead of riskier bets on high-growth, cash-burning companies typical in the unicorn crowd, he said.

Combine these factors together and “we’re going to see a lot of busted unicorn horns,” Kinsella said.